I thought hedged return= return on local currency + forward discount (premium). So shouldn’t the net advantage be 2.5%? What am I missing here?
rawlings evalauates 2 bonds and decides that over the next three months, he will invest in bond D (issued by dynacom, den in $) He notes although bond B (issued by bergamo metals den in €) has a yield advantage of 1% over the next quarter, the euro is at a three month forward discount of approximately 1.5%. Therefore he favors bond D because of the net advantage for bond D is 0.5% over the next three months.
If there is an effective currency hedge the return should only be from the bond yield. Although efficient markets (from IRP) will ensure that there is no advantage once hedged and you should be indifferent between D and B.
In an unhedged return you need to account for the change in the FX rates. In the question the forward discount rate means that the the EUR futures are in backwardation. To sell futures of the EUR to hedge the Bergamo bond you need to take a lower price than the spot market. According to IRP the discount comes from the interest rate differential. Given than B has a positive yield differential you’d expect (given equal risk profiles) and depreciation in the EUR over the life of the bond.
Unhedged return=1-1.5
Hedged return=1+basis risk
Also if Duration is provided this could change the way the question is approached to the -spread change/duration formula.